SOLUTIONS ECO 209Y (L0201/L0401) MACROECONOMIC THEORY. Midterm Test #3. University of Toronto February 11, 2005 LAST NAME FIRST NAME STUDENT NUMBER

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1 Department of Economics Prof. Gustavo Indart University of Toronto February 11, 2005 SOLUTIONS ECO 209Y (L0201/L0401) MACROECONOMIC THEORY Midterm Test #3 LAST NAME FIRST NAME STUDENT NUMBER INSTRUCTIONS: 1. The total time for this test is 50 minutes. 2. This exam consists of two parts. 3. This question booklet has 5 (five) pages. 4. Aids allowed: a simple calculator. 5. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I /15 Part II 1. /10 2. /10 3. /10 TOTAL /45 /100 Page 1 of 5

2 PART I (15 marks) Instructions: Circle the most appropriate answer. Each question is worth 3 (three) marks. No deductions will be made for incorrect answers. 1. In a closed economy, the aggregate demand (AD) curve will be flatter a) the larger the interest sensitivity of the demand for real balances (h) is b) the larger the interest sensitivity of investment (b) is c) the larger the income sensitivity of the demand for real balances (k) is d) the smaller the aggregate expenditure multiplier (α AE ) is e) none of the above are correct 2. An increase in the price level will cause a) the aggregate demand (AD) curve to shift up to the right b) the aggregate demand (AD) curve to shift down to the left c) a movement up along the aggregate demand (AD) curve d) output to fall in the Classical model e) both a) and d) are correct 3. A profit-maximizing firm will hire additional units of labour a) as long as the nominal wage rate is greater than the value of the marginal product of labour b) as long as the nominal wage rate is smaller than the marginal product of labour c) as long as the real wage rate is greater than the marginal product of labour d) up to the point where the marginal product of labour is equal to the nominal wage rate e) as long as the value of the marginal product of labour is greater than the nominal wage rate 4. In the Classical model, an increase in the price level will a) reduce the quantity demanded of labour b) increase the quantity supplied of labour c) reduce the equilibrium quantity in the labour market d) leave the equilibrium real wage rate unchanged e) none of the above 5. If both the supply of labour and the demand for labour depend on the real wage rate, then an increase in autonomous investment will cause a) price, output, and nominal wage to increase, but real wage to fall b) price and nominal wage to increase, but output and real wage to fall c) price and nominal wage to increase, while leaving output and real wage unchanged d) price, nominal wage, and real wage to increase, while leaving output unchanged e) all price, output, nominal wage, and real wage to increase Page 2 of 5

3 PART II (30 marks) Instructions: Answer true, false, or uncertain to the following statements in the space provided (if the space is not sufficient, continue on the back of the previous page). Be sure to justify your answers (no justification, no marks!). Each question is worth 10 (ten) marks. 1. If money wages are fully flexible, expansionary fiscal policy will be effective only if workers suffer from money illusion. (Show your answer with the help of graphs and explain the economics.) True Money illusion refers to the tendency of people to think in nominal rather than in real terms. Workers, for example, suffer from money illusion when they believe that an increase in nominal wages (i.e., the price of their product, labour) makes them better off even if the price level in the economy has also increased by the same percentage or more. If workers suffer from money illusion, then changes in P will not affect their decisions as to how much labour to supply, i.e., changes in P will leave the position of the labour supply curve unchanged. In the model developed in class, the expression for the supply of labour would be W = g(n) curve N S (P 0 ) below. The assumption here is that workers will offer more labour if money wages increase. If workers do not suffer from money illusion, then changes in P will affect their decisions as to how much labour to supply, i.e., changes in P, which reduce real wages, will shift the labour supply curve up to the left. In the model developed in class, the expression for the supply of labour would be W = P.g(N) for simplicity, also curve N S (P 0 ) in diagram below assuming that P 0 = 1. The assumption here is that workers will offer more labour if real wages increase. Since firms are assumed not to suffer from money illusion, then changes in P will affect their decisions as to how much labour to demand, i.e., changes in P, which reduce real wages, will shift the labour demand curve up to the right. In the model developed in class, the expression for the demand for labour would be W = P.MP N curve N D (P 0 ) below. The assumption here is that firms will demand more labour if real wages decrease. If neither firms nor workers suffer from money illusion, then, as G increases and P starts to rise, both the labour demand and the labour supply curves will shift up in the same proportion to N D (P 0 ) and N S (P 0 ) in diagram below, and thus the level of equilibrium N will remain unchanged (and thus P and W will increase in the same proportion, and W/P will remain unchanged). If equilibrium N doesn t change, then equilibrium Y will also remain as before. Therefore, expansionary fiscal policy is ineffective in this case. This is the Classical case, where the AS curve is vertical (at the level of full-employment Y) curve AS 0 below. If workers suffer from money illusion, then only the demand for labour curve will shift up -- to N D (P 1 ) -- when P increases to P 1 as a result of the increase in G. Here, then, the equilibrium level of N will increase, and thus the equilibrium level of Y will also increase. In this case, the AS is positively sloped curve AS 1 below -- and expansionary fiscal policy is effective with respect to output. W P AS 0 N S (P 0 ) W 0 P 0 AS 1 N S (P 0 ) P 1 W 1 N D (P 0 ) P 0 AD W 0 N D (P 1 ) N D (P 0 ) AD N 0 N 1 N Y 0 Y 1 Y Page 3 of 5

4 2. Consider a closed economy with rigidities in the labour market such that the nominal wage rate cannot adjust downwards. Suppose that this economy is initially in equilibrium at the level of full employment output. Under these conditions, if the Bank of Canada increases the nominal supply of money, then the price level will increase but the level of output will remain unchanged since the equilibrium level of employment will not changed. (Show your answer with the help of graphs and explain the economics.) False If nominal wages cannot adjust downwards, then the labour supply curve will be horizontal (at the initial equilibrium nominal wage) up to the initial equilibrium level of employment (N*) and then it will have a positive slope. Note that in this model labour supply is independent of the price level, i.e., there is money illusion on the part of workers. In this model, therefore, the AS curve will have a kink (at Y*), but the slope will be positive throughout. An increase in the nominal money supply will shift the LM curve down to the right, increasing aggregate demand and causing the AD curve to shift up to the right (investment expenditure will increase because of the lower rate of interest). The increase in AD will create a situation of excess demand at the initial equilibrium price level, thus putting an upward pressure on P. The ensuing increase in the price level triggers an adjustment on both the supply and the demand sides of the economy. On the supply side, as P increases the demand for labour increases since the real wage rate falls at each level of the nominal wage rate. In other words, the demand for labour curve shifts up to the right (i.e., a greater quantity is demanded at each level of the nominal wage). Note that the supply of labour does not change since it s independent of P. Therefore, the level of employment rises above the initial equilibrium N*, and so the level of output also increases above the initial equilibrium Y*. The nominal wage rate also increases to W1, but the real wage rate decreases since firms are now hiring a greater quantity of labour (i.e., P increases in greater proportion than W does). On the supply side, therefore, the adjustment is along the AS curve: P increases and Y also increases. On the demand side, as P increases the quantity demanded of goods and services starts to decrease along the new AD curve. This is due to the fact that the increase in P causes the real supply of money to decrease (i.e., the LM curve shifts back to the left), and thus the quantity demanded of goods and services decreases as i rises. The adjustment on the demand side is along the new AD curve and along the new IS curve. The statement is therefore false: the rate of interest falls and the level of equilibrium output increases, and thus the equilibrium level of employment increases as well. i W P LM(P 0 ) LM (P 1 ) N S LM (P 0 ) W 1 P 1 AS IS W 0 P 0 N D N D AD AD Y* Y 1 Y 0 Y N* N 1 N Y* Y 1 Y 0 Y Page 4 of 5

5 3. Consider a flexible-price model with perfect capital mobility and flexible exchange rates, where the economy is initially in long-run equilibrium. The short-run aggregate supply (SAS) curve is give by the expression: P = P -1 [1 + λ(y Y*)]. Under these circumstances, expansionary monetary policy will be completely ineffective in both the short- and the longrun. (Show your answer with the help of graphs and explain the economics.) False An increase in the nominal supply of money will cause the LM curve to shift down to the left from LM 0 (P 0 ) to LM 1 (P 0 ) (see diagram below). Given the assumption of perfect capital mobility, the ensuing fall in the interest rate will cause a massive outflow of capital and the Canadian dollar will depreciate. The depreciation of the Canadian dollar will cause NX to increase, and thus the IS curve will shift up to the right from IS 0 (P 0 ) to IS 1 (P 0 ). At the price level P 0 the quantity demanded of goods and services will increase from Y* to Y 0. Therefore, the AD curve will shift up to the right from AD 0 to AD 1 where the horizontal shift will be equal to Y 0 - Y *. As shown in the AD-AS diagram, there is now an excess demand at P = P 0, and thus P will start to rise. The adjustment on the supply side is along the SAS 0 curve: P increases and Y also increases (because as P increases, the demand for labour increases, and equilibrium income also increases from N* to N 1 ). Equilibrium will be re-established at the point where the SAS 0 and AD 1 curves intersect, and thus output will increase to Y 1 and the price level will rise to P 1. Point E 1 is thus the new short-run equilibrium. The adjustment on the demand side is along the AD 1 curve: as P increases the quantity demanded of goods and services decreases. This can be seen in the IS-LM-BP diagram. The increase in P will reduce the real money supply, and thus the LM curve will shift up to the right from LM 1 (P 0 ) to LM 1 (P 1 ). The increase in P will also reduce the value of the real exchange rate, and thus NX will decrease and the IS will shift down to the left from IS 1 (P 0 ) to IS 1 (P 1 ). The quantity demanded is thus reduced from Y 0 to Y 1 as P increases from P 0 to P 1. In the short-run, therefore, expansionary monetary policy is effective in the sense that equilibrium income rises above Y*. In the medium-run, however, the SAS curve starts shifting up to the left as the price level of the previous period increases. This will cause P to rise and Y to fall period after period until a new long-run equilibrium is re-established at E 0, where the level of output is again equal to Y* but the price level is higher at P 0. In this model, therefore, expansionary monetary policy has a positive effect on equilibrium output only in the short-run. In the medium-run the positive effect of expansionary monetary policy starts to get diluted, and in the long-run the effect completely disappears. Thus, it could be said that expansionary monetary policy is ineffective in the long-run. The statement is thus false since expansionary monetary policy is effective in the short-run. i P LM 0 (P 0 ) = LM 1 (P 0 ) LAS IS 0 (P 0 ) = IS 1 (P 0 ) SAS 0 LM 1 (P 1 ) P 0 E 0 LM 1 (P 0 ) SAS 0 E 0 = E 0 E 1 B i* P 1 E 1 P 0 B E 0 AD 1 IS 1 (P 1 ) IS 1 (P 0 ) AD 0 Y* Y 1 Y 0 Y Y* Y 1 Y 0 Y Page 5 of 5